Hedged Value

Market Commentary

Period ended June 30, 2016

The Hotchkis & Wiley Hedged Value strategy returned +1.6% during the second quarter of 2016, net of fees.  The S&P 500 Index returned +2.5%, the Russell Developed Index returned +1.2%, and the HFRI Equity Hedge Index returned +1.4%.  Since the beginning of the year, the Hotchkis & Wiley Hedged Value strategy returned +3.8%, net of fees, the S&P 500 Index returned +3.8%, the Russell Developed Index returned +1.1%, and the HFRI Equity Hedge Index returned -0.4%.   

PERFORMANCE REVIEW: 2Q 2016

Long energy positions had the largest positive performance impact over the quarter, as crude prices rose more than 25%.  While several long equity positions appreciated considerably, long energy credits had the largest positive influence on performance—we identified several credits trading at a small fraction of par despite sufficient asset coverage under even highly punitive commodity price scenarios.  The portfolio’s financials exposure was the second largest performance contributor during the quarter, as both the longs and the shorts moved in our favor.  While our gross and net financials exposure is dominated by banks, it was our long and short positions in asset managers that positively affected performance in the quarter.  Our sole short position in telecom also moved in our favor helping the quarter’s performance.  On the negative side, our long consumer discretionary exposure detracted from performance.  The principal culprit was an office retailer that declined following a judge’s ruling against its proposed merger.  While we understood from the outset that there was a risk that the deal might be rejected, and in such a scenario the price of the stock was likely to decline, the ultimate reaction in the stock immediately following the decision proved to be well beyond what we thought the business’s standalone fundamentals justified.  This substantial overreaction in the stock’s price hurt performance in the short term but gave us the opportunity to add to our position at what we feel was a very attractive price. Energy shorts moved against us, unsurprising given the rise in oil prices, though this was overshadowed by the positive performance from the energy longs.  A couple of short positions in materials moved against us, also due to the rise in commodity prices. 

Expectations of near-term Fed rate hikes have waned following recent FOMC meetings, which all else equal should have weakened the dollar.  The dollar did in fact weaken versus the Japanese Yen, depreciating by 8%.  Britain’s vote to exit the European Union, however, trumped changing interest rate expectations.  The pound declined 7% and the Euro declined 2% (both versus the U.S. dollar).  The portfolio is considerably overweight U.K.-listed stocks on the long side, though the exposure is centered on companies with a vast global footprint.  Exposure to companies operating either exclusively or predominantly within U.K. borders remains relatively contained.  Accordingly, our outsized U.K. exposure had little effect on relative performance during the quarter, other than a modest currency drag.  

PORTFOLIO ACTIVITY AND OPPORTUNITIES: 2Q 2016

There was wide performance dispersion across equity sectors during the quarter, with the S&P 500’s best-performing sector (energy) outperforming the worst-performing sector (technology) by more than 14 percentage points.  Despite the partial rebound in energy this quarter, over the last 12 months we have observed a massive flight away from cyclical market segments in favor of non-cyclicals.  Pundits have described this trend as “risk off”, “flight to safety”, “low volatility”, “bond proxy” etc. but the reality is that non-cyclical businesses now appear to trade at an unusually high premium to cyclical businesses.  Macroeconomic shocks like Brexit have only exacerbated the divergence.  True to Benjamin Graham, we view stocks trading at discounts to intrinsic value as having a margin of safety.  Ironically, it has become difficult to identify a margin of safety in businesses currently perceived as “safe” because their valuations have become stretched.  The most attractive individual opportunities reside within financials and energy, which represent the portfolio’s largest gross and net exposures.  We do not know when value dislocations will revert, nor are we certain that these dislocations will not widen further before reverting.  We have learned from past experience, however, that these cycles inevitably do normalize and we believe that our portfolio is well-positioned to benefit.  Bifurcated valuations have led to an increase in our gross exposure to 180%, which is about as high as we expect it to ever get barring extreme circumstances. 

We increased our long exposure by 1% and increased our short exposure by 4%; hence, our gross exposure increased by 5% and our net exposure declined by 3%.  Our long exposure was relatively flat or modestly decreased in all sectors except energy, where it increased slightly.  Though we trimmed several strong-performing longs the sector’s outperformance caused the increased net exposure.  While not all areas within the energy sectors are compelling, we have found numerous long opportunities across the capital structure, predominantly in upstream energy companies.  These holdings are positively exposed to crude oil prices, which we believe remain well below sustainable levels.  We believe the oil market will experience a meaningful supply shortage within a reasonable timeframe putting upward pressure on the commodity price.  Since peaking in June 2015, domestic crude oil production has declined by more than 10%; we do not see a way for these declines to ease or reverse without a substantially higher crude price.  Accordingly, we believe there is risk that the price of oil rises beyond what most investors, including us, would view as normal.  As such, select investments within energy represent truly uncommon opportunities. 

Interest rates declined during the quarter, largely influenced by investors’ flight to US Treasuries in the aftermath of Brexit.  The low rate environment has been a stubbornly persistent macroeconomic headwind for most financials, with banks disproportionately affected because their net interest margins are pressured.  From a bottom-up fundamental perspective, however, the strengthening posture of US banks has been quite encouraging.  Profitability has been solid and capital ratios are at/near all-time highs.  All companies subjected to the Fed’s stress test have passed, which improves the potential for increased returns of capital to shareholders.  Buying back shares at/below book value can be highly accretive and this group’s payout yield (dividends + share repurchases) currently stands at 8%1.  Financials represent the portfolio’s second largest sector (both gross and net). 

CONCLUSION

The wide valuation spreads in the current equity market present value investors with some uncommon opportunities, on both the long and short side.  Valuation will continue to be our guiding beacon, and we are optimistic regarding the portfolio’s prospects as we look forward.  

 

1Source: Empirical Research

Information provided is based on a representative portfolio of the Hedged Value (HV) strategy. Client portfolios managed using the strategy may hold different securities or different weightings of securities due to different guideline restrictions, cash flows, and other relevant considerations. Equity performance attribution is an analysis of the portfolio's return relative to a selected benchmark. Sector level performance is measured on both long and short gross exposures. Derivative securities are categorized based on the economic exposure to the relevant underlying security/securities. Returns are calculated using daily holding information and do not reflect transaction costs, fees and expenses. Options are delta-adjusted. Returns calculated using this buy-and-hold methodology can differ from actual transactions based portfolio returns. 

The performance shown for the Portfolio reflects the reinvestment of dividends and earnings.  The net performance results also reflect transaction costs and other expenses and the deduction of a quarterly 0.25% management fee and an annual 20% performance allocation to H&W.  The Portfolio whose performance is shown is a pooled investment fund (the “Fund”), which also generally incurs general administration, auditing, legal and other operating expenses that are currently being paid by H&W and thus not reflected in the net returns shown; the fund may pay such expenses in the future, however, which will reduce its net returns.  In calculating the net returns, the 20% performance allocation has been calculated as if it were allocable at the end of the quarter, rather than annually. 

The Portfolio returns shown represent the returns experienced by a hypothetical investor who invested capital on January 1, 2014, with no subsequent contributions or withdrawals, and who is not eligible to receive “new issue” profits and losses.  Actual returns experienced by individual investors vary depending on their date of investment and other factors. The performance of the Portfolio was calculated by H&W and has been compiled, reviewed and verified by an independent accountant.

Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods. The strategy invests in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. Investing in small and medium-sized companies involves greater risks than those associated with investing in large company stocks, such as business risk, significant stock price fluctuations and illiquidity. All investments contain risk and may lose value.  The strategy may concentrate its assets in fewer individual holdings. Certain hedging techniques and leverage employed in the management of the HV strategy may accelerate the velocity of possible losses.  Short selling involves the risk of potentially unlimited increase in the market value of the security sold short, which could result in potentially unlimited loss for the portfolio.  While H&W believes that during the period for which performance is shown, the Portfolio was managed with an investment philosophy and methodology similar to that H&W will use to manage the Strategy in the future, future investments will be made under different economic conditions and in different securities. Gross and net exposure change daily and on any date may vary significantly from the exposure data shown. Depending on conditions and trends in securities markets and the economy generally, H&W may vary the composition and exposure of HV portfolios and exposure and pursue any objectives, employ any techniques or invest in any type of security that it considers appropriate and in investors’ best interests.

The performance shown represents investment of limited funds for a limited period of time and does not reflect performance in different economic cycles.   The performance information shown is historic and should not be taken as any indication of future performance.

The performance of the S&P 500 Index, Russell Developed Index and the HFRI Equity Hedge Index is not directly comparable to the Portfolio’s performance.  Portfolios managed using the Strategy are much less diversified than any of those indices. The S&P 500 Index is an unmanaged index of long-only equity positions that reflects the general performance of the U.S. equity market, the Russell Developed Index measures the performance of investible securities in developed markets globally, while the Strategy allows H&W to take short positions, use margin and invest in options, futures and other derivatives.  The HFRI Equity Hedge Index is an index of equity hedge fund returns and reflects a diverse range of investment instruments, techniques and strategies. The presentation of index data does not reflect a belief by H&W that any such index, or an aggregation of them, represents a comparable investment alternative to the Strategy.

The commentary is for information purposes only and should not be considered as investment advice or a recommendation or offer of any particular security, strategy or investment product. Portfolio managers’ opinions and data included in this commentary are as of June 30, 2016 and are subject to change without notice. Any forecasts made cannot be guaranteed.  Information obtained from independent sources is considered reliable, but H&W cannot guarantee its accuracy or completeness. Certain information presented is based on proprietary or third-party estimates, which are subject to change and cannot be guaranteed.  Investing in value stocks presents the risk that value stocks may fall out of favor with investors and underperform growth stocks during given periods. All investments contain risk and may lose value. 

Composite performance for the strategy is located on the Performance tab. Returns discussed can differ from actual portfolio returns due to intraday trades, cash flows, corporate actions, accrued/miscellaneous income, and trade price and closing price difference of any given security. 

Past performance is no guarantee of future results.

Index definitions